Wednesday, October 21, 2009

Defrauding Pension Plans?

The California attorney general’s office has charged the State Street Corporation with fraud, accusing the company of cheating the state’s two largest pension funds of at least $56.6 million by overcharging them for a series of foreign exchange trades.

The lawsuit, unsealed on Tuesday by a Sacramento Superior Court judge, contends that State Street currency traders consistently overcharged the two state pension funds, Calpers and Calstrs, for the costs of managing their accounts since 2001, and then concealed the charges.

The California attorney general is seeking to recover $200 million in overcharges and penalties.

“State Street bankers committed unconscionable fraud by misappropriating millions of dollars that rightfully belonged to California’s public pension funds,” said Jerry Brown, the California attorney general. “This is just the latest example of how clever financial traders violate laws and rip off the public trust.”

Carolyn Cichon, a spokeswoman for State Street, which is based in Boston, said the bank categorically denied any allegations of wrongdoing and would defend itself against any litigation.

The lawsuit is the latest in a string of recent legal headaches for State Street, a bank that has long flown under the radar of ordinary investors but plays a crucial role in the global financial system in booking trades, lending securities and providing other services to hedge funds, pension funds and investment firms. Federal regulators considered it one of 19 too-big-to-fail banks in the recent stress tests.

State Street has faced multiple regulatory investigations and shareholder lawsuits over whether it misled investors about the risk in certain bond fund, derivatives, and subprime mortgage-related investments. One lawsuit was filed in April on behalf of the Sisters of Charity of the Blessed Virgin Mary.

It also comes as State Street is struggling to regain its financial footing. After passing the stress tests this spring, federal officials put them alongside JPMorgan Chase, Goldman Sachs and eight other large banks that were among the first to repay their taxpayer investments.

State Street announced on Tuesday a $516 million profit in the third quarter, but its shares fell 8.4 percent, its biggest drop in five months, on the news of the lawsuit and a sobering earnings forecast.

Ronald E. Logue, State Street’s chief executive, said the bank expected earnings to decrease by about 16 percent, worse than the 12 percent decline projected earlier this year.

Bank of New York Mellon, another big custodial bank, reported a $2.46 billion third-quarter loss on Tuesday, but its shares rose 6.1 percent.

Still, the lawsuit raises troubling questions about the bank’s practices and controls. It grew out of an inquiry by California state investigators who were looking into claims made against State Street by unidentified whistle-blowers that accused the bank of adding a secret and substantial markup to the price of their currency trades. The whistleblowers alleged that the scheme cost State Street clients about $400 million annually and dated back to 1998.

According to the California Attorney General, State Street executed about $35.2 billion in currency trades for Calpers, the California Public Employees’ Retirement System, and Calstrs, the California State Teachers’ Retirement System, from 2001 to this fall.

State Street tellingly referred to the state pension funds as “dumb” clients since they allowed the bank to handle foreign exchange transactions for them, according to a complaint filed by the whistleblowers. Smart clients, it said, traded directly with the bank and obtained better rates.

The lawsuit contends that State Street concealed fraudulent pricing practices by entering false exchange rates into electronic trading databases and reporting false prices in the account statements that it provided Calpers and Calstrs. The lawsuit also accuses State Street of deliberately failing to include time stamp data in its reports so that the pension funds could not verify the actual cost of the trade.

If the California attorney general is successful, the whistle-blowers who filed the original sealed lawsuit could receive a share of any money recovered.

As pension plans face mounting financial strains, they will be scrutinizing every relationship, including the ones with their big custodial banks. If there is any truth to these allegations, State Street will see many of their pension clients switching to another custodial bank.

“You have to put in something where there is downside to people who really mess up large institutions,” Buffett said in an interview conducted by the chief executive officer of Business Wire, the Berkshire subsidiary that posts corporate press releases. “Too many people have walked away from the troubles they have created for society, not just for their own institution, and they have walked away rich.”

Wall Street bonuses for 2009 may jump 40 percent to $26 billion, a year after bad bets on subprime mortgages sent financial firms to the government for bailouts, according to estimates by compensation consultant Johnson Associates Inc. Buffett became the second-richest American by building Omaha, Nebraska-based Berkshire into a $150 billion company.

“What you have to change in Wall Street, is you have to make sure that in addition to carrots, there are sticks,” he said. “And it can’t be a one-way street where they are making ungodly amounts of money when things are good and then they move on to someplace else for a while when things are bad.”

Goldman Sachs

Buffett invested $5 billion of Berkshire’s money last year into Goldman Sachs Group Inc., Wall Street’s highest paying and most profitable firm. He said in the interview that the securities industry is essential to economic growth.

“I don’t look at Wall Street as ‘evil,’” he said. “I look at Wall Street as given to huge excess sometimes. I don’t want to get rid of it. We need something to allocate capital and distribute securities and all of that throughout the system. We have got a big capitalist system and we have to have a big capital market - but there is plenty of room for improvement.”

Banks worldwide reported more than $1.1 trillion of credit losses and writedowns tied to the mortgage meltdown since 2007, according to Bloomberg data. The property slump helped topple CEOs at Citigroup Inc. and Merrill Lynch & Co., and pushed the Standard & Poor’s 500 Index to a 12-year low in March.

Kenneth Lewis

President Barack Obama’s administration is seeking to overhaul regulation of Wall Street and curb some pay packages, even as a seven-month stock rally has helped restore profits to the banking industry. Kenneth D. Lewis, in his last year as CEO of Bank of America Corp., won’t receive a 2009 salary or bonus on the recommendation of U.S. pay supervisor Kenneth Feinberg.

Buffett has criticized bankers for not guarding against the housing slump and blamed them for the worst recession in half a century.

“I think that virtually everybody associated with the financial world contributed to it,” Buffett said in a May news conference after the Berkshire’s annual meeting in Omaha. “Some of it stemmed from greed, some from stupidity, some from people saying the other guy was doing it.”

Wall Street bonuses in 2008 fell 44 percent from the prior year to $18.4 billion, according to New York state Comptroller Thomas DiNapoli.

Goldman’s Pool

Goldman, led by CEO Lloyd Blankfein, set aside $16.7 billion to pay employees so far this year. That’s enough to pay each worker $527,192. The New York-based bank repaid $10 billion it got from Treasury and reported a jump in third-quarter profit. JPMorgan Chase & Co., which repaid $25 billion of U.S. funds, said profit surged almost sevenfold in the quarter.

The Buffett interview, conducted last month, was released today in connection with the launch of a Web site, PYMNTS.com, by Business Wire focusing on the electronic payments industry. Buffett is chairman and CEO of Berkshire.

It's not just Wall Street pay that needs a downside. The pay of senior pension fund managers needs a downside too, especially when they report disastrous results like in 2008. We need to revamp the compensation practices on Wall Street and at public pension funds that take on far too much risk, focusing on short-term gains. And these reforms are needed urgently.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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